Investors are unsure of what they pay for

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Investing in mutual funds is a leap of faith. You give money to a firm in the hope of getting professional management and diversification at a reasonable price.

But it's a big leap of faith when you're not entirely sure how mutual funds work. Judging from these questions recently received from readers, some investors clearly remain a bit mystified:

Why are you and every other expert so concerned about costs? Hedge funds charge a lot more money than ordinary mutual funds, but they also make a lot more [in returns]. So why shouldn't I pay more in costs if a fund is giving me better returns? You may own a fund that's cheaper, but I'll have more in the end.

- Keith in Emmaus, Pa.

If you could guarantee the higher return, paying the higher expenses would be justifiable. But there's no guarantee on returns, just on costs. So if you can set the hurdle that a manager has to clear before their performance comes home to you, would you want to set the bar at 0.5 percent or at 2 percent? The manager facing higher costs has to squeeze more from the market to deliver the same returns down the line to shareholders.

Mind you, there are funds that have overcome the hurdle - and which may inspire confidence that they can do it again - and there are plenty of low-cost funds that have stumbled over their lower bar, so the expense issue doesn't always play out as expected. But unless management can convince you that it is worth a bigger fee - and that your additional dollars will be rewarded with a greater return - you will always be better off investing in the fund with the cost structure that makes you most comfortable.

As for hedge funds, the typical 2-20 fee structure - where management takes a 2 percent fee, plus 20 percent of any profits - is a big part of the reason why investors frequently shut down hedge funds that suffer through a small bad patch. Moreover, hedge fund investors routinely say that they only pay those prices when they believe the manager can deliver superior results; there's no reason for an individual investor to act differently.

I am trying to decide if I should invest in an exchange traded fund or a mutual fund. I realize there is more cost with a managed mutual fund but would my returns possibly be higher as compared with a passively managed account like an ETF?

- Frank in Hoboken, N.J.

Don't confuse the cost issue with management-style concerns. Exchange-traded funds are built like index mutual funds, but trade like stocks. They are a low-cost way to invest, but most investors would not be able to tell the difference between an index fund or an exchange-traded fund tracking the same underlying index.

Index funds of either type represent a terrific low-cost way of capturing the return of the benchmark. The issue for many investors is that with any index fund, you are buckling up to go for the whole ride, downturns and all; there is no manager making moves to try to avoid a downturn, just the experience of the index. In time, that bumpy ride may provide an ideal return, but only for those shareholders who can ride it out.

There's also no denying the research which says that the average manager has an extremely hard time outperforming the benchmarks their funds are tied to, meaning that it's the rare, superior manager who can deliver superior returns.

The decision should come down to which type of management most inspires your confidence, and gives you the courage to stay with your pick through thick and thin. If you need a manager at the helm to have conviction in your choice - and if that manager delivers even average performance in the asset class - then the extra cost for going with an actively managed fund will be worth it in the end.

You said performance surfing was bad, but what's wrong with buying a fund that "makes the top of the charts"? Don't I want funds that do that?

- Richard in Metarie, La.

Topping the quarterly charts for all funds requires so much specialization these days that funds that can do it tend to be highly specialized. Unless you know how to work with the power tools - like leveraged funds - that achieve that status, it's dangerous to go there.

Even within individual asset classes, reaching the top of the charts sometimes means a manager is taking above-average risks, or the fund is taking a strategy that is misplaced in the category. Funds that reach the top of any grouping are equally capable of hitting the skids and dropping to the bottom; there's a difference between purchasing a quality fund and simply buying into market volatility.